What Is An Automated Market Maker?
Decentralized exchanges (DEXs) work on a protocol, which is the automated market maker (AMM). It is an automated trading mechanism that eliminates the need for centralized exchanges. Uniswap was the first decentralized platform to use the Automated Market Maker system.
What is an AMM?
Centralized exchanges work with intermediaries, while DEXs aims to eliminate those from crypto trading. DEXs promote autonomy so that users have complete control over their wallets and can initiate transactions as per their will.
DEXs replace order matching systems with autonomous protocols, AMMs. Prices of digital assets are defined and liquidity is maintained by these protocols that use smart contracts. The protocol pools liquidity into smart contracts. So, here, when a user is trading, it isn’t against a counterparty but rather against the liquidity in the smart contracts. Hence, these smart contracts are referred to as liquidity pools.
Some examples of AMMs include Curve, Balancer, and Uniswap.
How do AMMs work?
In AMMs, the trading pairs that exist on a centralized platform exist as individual liquidity pools. So, when you want to trade ether with USDT, there is an ether/USDT liquidity pool. Unlike centralized exchanges, there are no dedicated market makers. Anyone can provide liquidity by submitting a certain ratio of ether and USDT.
AMMs use mathematical equations so that no discrepancy arises in the pricing of the pooled assets. Also, here, you don’t need another trader to make a trade; instead, you directly interact with a smart contract. The transactions are peer-to-peer and happen directly between wallets.
When large trades take place, say, for instance, someone buying a lot of ether in exchange for USDT, this leads to an increase in the price of ether and a decrease in the price of USDT. This creates a discrepancy in the asset’s price in the market and the pool, which creates an arbitrage opportunity.
Arbitrage trading is a strategy to find assets with low prices on one platform and sell them on another where there are higher prices for them. And for AMMs, there are incentives for arbitrage traders to keep buying an asset whose price has dropped until it reaches its market value.
Final Thoughts
On centralized exchanges, there are dedicated market makers, while DEXs have automated market makers for that. AMMs are protocols run by smart contracts that provide liquidity and define the price of digital assets.
At Kointrack, we make blockchain technology accessible to more people and bring you the latest information on the current trends in the crypto market.
